The process involves a fund segregating papers that are illiquid or in default category from all other instruments in the portfolio that are liquid.

In the wake of the IL&FS crisis, the mutual fund industry is keen the regulator allow schemes with exposure to bonds issued by troubled companies to use side pocketing.

What is side pocket?A ‘side pocket’ option allows a fund house to separate bad assets or risky ones from other liquid investments in a debt portfolio which could get impacted by the credit profile of underlying instruments. Using this accounting process, you can insulate small investors from being hit by sudden exits of large investors. Side-pocketing helps stabilise the net asset value (NAV) and reduces redemptions the scheme. Incase the illiquidity event is sudden, side-pocketing provides a cushion to the liquid portfolio.

What is the process?The process involves a fund segregating papers that are illiquid or in default category from all other instruments in the portfolio that are liquid. This creates two schemes ---one containting the illiquid paper and the other holding the good ones.

Why is this useful?A fixed income fund with a corpus of Rs 1000 crore has a exposure of Rs 60 crore to a defaulting company. The balance Rs 940 crore is held in good companies. Due to the default, large investors prefer to redeem their money from the scheme to avoid any further loss. To pay these investors, fund managers are forced to sell good paper, while the bad papers because of the illiquidity and no buyers remain in the fund itself. The percentage holding of bad assets in the total portfolio rises. This often leads to sharp drop in the NAV which hits investors in the fund. To prevent such a situation, the fund may segregate the debt papers of the affected company , while the rest of the good papers remain in the original fund and thus the good paper is unaffected by the bad papers. All the investors of the original fund will also get units of the side pocketed funds. As and when the affected company pays back, the investors will get their money back.

What are the disadvantages of side pocketing? Side pocketing should be used with caution. Since valuations of the illiquid or defaulted asset is contentious, NAV of the illiquid asset will not be discoverable. Two sets of NAV will be difficult for investors to track. Finally fund house should not misuse side pockets to protect managers’ fees on the more liquid assets or to hide poorly performing assets or poor liquidity management by its fund managers.